FINALS PREPERATION
Chapter 1: Key Issues in International Business Finance
KEY TAKEAWAY: Operating on an international scale brings many additional risks which must be dealt
with in order to remain successful
Reasons Why Countries Print Their Own Money
i)
ii)
iii)
It is a profitable endeavor
National Pride
Remain control over one’s monetary policy
Main points
-
Money does not have intrinsic value -> We must find other ways to value currencies
Governments in large part no longer control exchange rates -> Exchange Risk, from fluctuations,
must be understood
Prices Rise with GDP per Capita
Prices are Sticky and Exchange Rates Fluctuate -> Changes in exchange rate can have a
significant effect on a country’s competitiveness
Due to the above real exchange risk -> We must learn about currency forwards, futures, options
and swaps to mitigate these risks
Given that international operations involve more than one country -> A special type of credit
risk arises where no specific legal system has jurisdiction
Given this type of credit risks -> companies seek guarantees from financial institutions to offset
the risk
Political Risk -> Entails transfer risks which must be taken into account by companies
The main risks to be considered by a company operating internationally is real exchange,
credit and political risk -> The point of this book is understanding how to hedge these risks
Difference in the International Market:
Value Added = K(R-CoC)



Expanded Opportunity Set: More places to raise money which lowers Cost of Capital
Market Imperfections: Taking advantage of differential tax rates, import restrictions, etc.
FX and Political Risk: FX movements can impact a firm’s profitability and competitiveness.
Political risk includes such factors as expropriation of assets
Glossary



Credit Risk: The risk of loss of principal or loss of a financial reward stemming from a borrower's
failure to repay a loan or otherwise meet a contractual obligation
Transfer Risk: The risk associated with the possibility of a currency not being able to be sent out
of the country, usually due to central bank restrictions or a national debt rescheduling
Value at Risk: A statistical technique used to measure and quantify the level of financial risk
within a firm or investment portfolio over a specific time frame.
Chapter 2: Institutional Background
Objective: Understand what money is and how it is traded in order to understand exchange rates (and
related risks and hedging)
Key Takeaways
The balance of payments theory of exchange rate: holds that the price of foreign money in terms of
domestic money is determined by the free forces of demand and supply on the foreign exchange
market.
Under a floating rate exchange
 If domestic exports a strong, the currency is likely to appreciate
 If foreign investment in domestic assets is strong, the currency is likely to appreciate
 Large Current account deficits, lead to positive Capital accounts/borrowing and indebtedness
Three Conditions for Money to be a Successful Least-Cost Medium of Exchange
i.
ii.
iii.
It must be storable (should not evaporate or rot)
Stable purchasing power
Easy to Handle
Takeaway: Today`s version of money is based on trust as opposed to intrinsic value. Thus, the value of
money is uncertain, which created exchange rate risks
Money Supply = M1 = m * M0 = m * (D+G+RFX)
Where:
-
M0: money base
M: money multiplier
D: Credit to the domestic private sector
G= Credit to the government
RFX = reserves of foreign exchange (including gold)
Ways that Central Banks Control the Money Supply
i)
ii)
iii)
iv)
Intervention in the foreign exchange markets: Central banks can influence the monetary
base by buying or selling forex
Open-Market Policy: Central banks can influence the monetary base by restricting or
expanding the amount of credit given to the government
Reserve Requirements: Also the central bank can curb money supply by changing the
reserve requirements on commercial banks (changing the upper bound of the money
multiplier)
Credit Control: The most direct way to control M1 is to impose limits on the amounts that
private banks can lend
Takeaway: Governments have the most control over the supply of money, and hence has the power
to change its value
Balance of Payments
i.
Sources (+): where the money was obtained for the international transaction
Uses (-): what we did with the money
Current Account: This entry records a country's net trade in goods and services, plus net
earnings from rents, interest, profits, and dividends, and net transfer payments (such as
pension funds and worker remittances) to and from the rest of the world during the period
specified.
𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝐶𝐴(𝑅)
Where:
Y= National Income/GDP
C = Consumer Spending
I = Private Investment
G = Government Spending
CA = Exports – Imports
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 = 𝑆 − 𝐼 − (𝐺 − 𝑇)
Where
S = Private After Tax Savings
G – T = Government Deficit
S = Y – (C-T)
If the current account is negative, the country is running a deficit, which must be financed by borrowed
funds, thus the capital account will be positive
Takeaway: The current account will be in a deficit situation if private after tax savings is not enough to
finance private investment and the government deficit
ii.
Capital Account: A national account that shows the net change in asset ownership for a
nation. The capital account is the net result of public and private international investments
flowing in and out of a country.
Direct Investment – in which the investor exerts some explicit degree of control over the assets
Portfolio Investment – in which the investor has no control over the assets
Other Investment – consists of various short-term and long-term trade credits, cross-border loans,
currency deposits, bank deposits and other A/R and A/P related to cross-border trade
The emergence of international money accounts has considerably weakened the link between the
balance of payments and the exchange market –> because international transactions does not
necessitate a currency exchange
Takeaway: While the BOP tells us whether a country’s asset portfolio is getting better or worse, the
NII account tells us how good or how bad things actually are, in an absolute, cumulative sense
Exchange Rate Regimes
Fixed Exchange Rates: require similar inflation rates across countries, which in turn, requires similar
economic policies
Examples
Bretton Woods Agreement:
-
Both the GBP and the DEM were fixed to the USD
This created a synthetic upper and lower band for the DEM/GBP
Different inflation levels in the U.K (high) and Germany (low) led to the collapse of the
agreement
U.K was forced to sell USD in order to keep its currency artificially high, and Germany had to buy
USD in order to remain artificially low. This led to an undersupply and oversupply of USD for the
U.K and Germany, respectively.
Glossary







Debasing: Reduce in quality or value
Money Base (M0): A measure of the money supply which combines any liquid or cash assets
held within a central bank and the amount of physical currency circulating in the economy.
M1: A measure of the money supply that includes all physical money, such as coins and
currency, as well as demand deposits, checking accounts and Negotiable Order of Withdrawal
(NOW)
Money Multiplier: Ratio between M1 and M0
Bilateral: involving two parties, especially countries.
Balance of Payments: The balance of payments, encompasses all transactions between a
country’s residents and its non-residents involving goods, services and income; financial claims
on and liabilities to the rest of the world; and transfers such as gifts
Net International Investment Position: A nation’s stock of foreign assets minus its foreign
liabilities. NIIP can also be defined as the value of overseas assets owned by a nation minus the
value of domestic assets owned by foreigners. The NIIP can therefore be regarded as a nation’s
balance sheet with the rest of the world at a specific point in time.
Chapter 3: Spot Markets for Foreign Currency
Objective: Understanding Spot Markets (𝑺𝑻 )
The convention used in this book to quote exchange rates is defined by “per”. Meaning 1.2 CAD/USD
translates into “1.2 CAD per USD dollar”
Furthermore the text uses a direct quotes where the base currency is the foreign currency, thus….HC/FC
Occurrence
Holidays, Weekends, Lunch Breaks
Low Volume
High Volatility
Spreads
Increase
Increase
Increase
Law of One Price
-
If two securities operate in a frictionless market and produce the same cash flow, they should
trade at the same price or else;
o Arbitrage opportunities exist until the prices become identical (if spreads don’t overlap,
an arbitrage opportunity exists)
o Shopping around, investors purchase the lower priced asset until prices become
identical
Law of Shaft: When calculating synthetic rates, the spread will always increase, benefitting the bank
In Class Example #1: Calculating Synthetic Rate Example
What are the synthetic bid & ask rates of AUD/GBP if:
2.4520-30
1.3840-50
-
AUD/USD
USD/GBP
Step 1: Ensure that the rates are set up properly (base currencies must not repeat)
Shortcut: Multiply the ask by the ask, and the bid by the bid
Step 2: Calculate the Ask
Step 3: Determine how much USD you need to buy 1 GBP (base currency)
o Answer: 1.3850
Step 4: Determine how much AUD you will need to purchase 1.3850 USD
o Answer: (2.4530/1)*1.3850 =3.3974/1.3850 USD or 1GBP
Step 5: Calculate the Bid
Step 6: Determine how much USD you get when selling 1 GBP (base currency)
o Answer: 1.3840
Step 7: Determine how much AUD you will get from selling 1.3840 USD
o Answer: (2.4520/1)*1.3840 = 3.3936/1.3840 USD or 1 GBP
Step 8: Sanity check – is the bid below the ask?
Step 9: Look for an arbitrage opportunity – if spreads overlap there is no arbitrage opportunity
In Class Example #2: Triangular Arbitrage



1 USD = 2 AUD (Bank 1)
1 AUD = 20 BEF (Bank 1)
1 USD = 38 BEF (Bank 2)
Here, since I can tell that 1USD should be worth 40 BEF, I will not buy BEF at Bank 2….rather I will sell
them there. I will take my 1 USD and sell it for 2 AUD, take my 2 AUD and exchange them for 40 BEF and
take 38 of those BEF and exchange them for 1 USD and have 2 BEF left over. I have made an arbitrage
profit of 2 BEF.
Purchasing Power of Parity
-
-
The purchasing power of parity adds an extra layer on top of exchange rates, measuring not only
the relative value of currencies, but comparing what each currency can purchase in its domestic
country. This means that if currency A is “stronger” than currency B, this does not necessarily
imply that the country with currency A is better off, if currency B purchases relatively more of a
domestic homogeneous product (e.g. a soda) in comparison with currency A.
Absolute Purchasing Power of Parity does not hold in reality (okay for commodities, CPP,
because relatively small deviations and friction costs, however doesn’t hold at all for consumer
goods)
𝑃𝑃𝑃 𝑟𝑎𝑡𝑒 =
𝜋 𝑑𝑒𝑛𝑜𝑡𝑒𝑠 𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙𝑠
𝜋
𝜋∗
Real Exchange Rate:
𝑅𝐸𝑅 =
𝑆𝑡 ∗ 𝜋 ∗
𝜋
𝑅𝐸𝑅 < 1: 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝐶𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑖𝑠 𝑟𝑒𝑙𝑎𝑡𝑖𝑣𝑒𝑙𝑦 𝑐ℎ𝑒𝑎𝑝
𝑅𝐸𝑅 > 1: 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝐶𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑖𝑠 𝑟𝑒𝑙𝑎𝑡𝑖𝑣𝑒𝑙𝑦 𝑒𝑥𝑝𝑒𝑛𝑠𝑖𝑣𝑒
If RER = 1 -> APPP is said to hold
Takeaway: A country with a RER below 1 -> it is difficult to export because the domestic currency is
relatively expensive


RPPP holds up well over the very long run but poorly for shorter time periods; and,
The theory holds better for countries with relatively high rates of inflation and underdeveloped
capital markets.
Glossary


Cross Rate: The currency exchange rate between two currencies, both of which are not the
official currencies of the country in which the exchange rate quote is given in. This phrase is also
sometimes used to refer to currency quotes which do not involve the U.S. dollar, regardless of
which country the quote is provided in.
Pip: One hundredth of a unit
Ch3: 2,3,5,6,9 and Applications:1,2,3,4,5
Chapter 4: Understanding Forward Exchange Rates
Objective: To use of spot, forward, home and foreign money markets in order to maneuver currency
transactions
Any transaction in one of these markets can be replicated by a combination of the other three
Arbitrage Computations Diagram:
PV Home
Currency
Domestic Interest Rate
Forward Exchange Rate
Spot Exchange Rate
PV Foreign
Currency
FV Home
Currency
Foreign Interest Rate
FV Foreign
Currency
Covered Interest Rate Parity Theorem
For there to be no arbitrage opportunities the following equation must hold:
𝐹𝑡,𝑇 = 𝑆𝑡
1 + 𝑟𝑡,𝑇
∗
1 + 𝑟𝑡,𝑇
𝑟𝑡,𝑇 Denotes domestic risk free return
∗
Swap Rate ≅ 𝑟𝑡,𝑇 − 𝑟𝑡,𝑇
Market Value of forward Purchase at 𝐹𝑡0,𝑇 =
𝐹𝑡,𝑇 − 𝐹𝑡0,𝑇
1+ 𝑟𝑡,𝑇
i.e. the present value of the new contract price – the old contract price
Expiration Value of forward contract with rate 𝐹𝑡0,𝑇 =
Initial Value of a Forward Contract with rate 𝐹𝑡,𝑇 =
𝑆𝑇 − 𝐹𝑡0,𝑇
𝐹𝑡,𝑇 − 𝐹𝑡,𝑇
1+ 𝑟𝑡,𝑇
=0
In Class Example #1
A company has a known cash payment of SF 50 million to be made to a Swiss supplier in 100
days. the company wishes to fix or lock in the nominal dollar price of this payment using
currently available rates. The spot rate available to the company is SF2.5/USD, the forward
swap rate for maturity in 100 days is -0.035, and the company faces a dollar interest rate of
12% and a SF interest rate of 6%. Given this information, what is the smallest dollar price on its
SF50 million that the co. can lock in with certainty? Explain the procedure the company will
follow to obtain this price. Does the synthetic forward rate equal the quoted rate? Is an
arbitrage opportunity available? Why or why not?
Glossary:





Swap rate: is the difference between the forward rate and spot rate
% Swap Rate: swap rate divided by the spot rate ->Premium (+), Discount (-) and Par (=)
Covered Interest Rate Parity Theorem: This term refers to a condition where the relationship
between interest rates and the spot and forward currency values of two countries are in
equilibrium
Interest Rate Parity: A theory in which the interest rate differential between two countries is
equal to the differential between the forward exchange rate and the spot exchange rate.
Forward Contract: A customized contract between two parties to buy or sell an asset at a
specified price on a future date. A forward contract can be used for hedging or speculation,
although its non-standardized nature makes it particularly apt for hedging. Unlike standard

futures contracts, a forward contract can be customized to any commodity, amount and delivery
date.
Futures Contract: A contractual agreement, generally made on the trading floor of a futures
exchange, to buy or sell a particular commodity or financial instrument at a pre-determined
price in the future. Futures contracts detail the quality and quantity of the underlying asset; they
are standardized to facilitate trading on a futures exchange.
Chapter 5: Using Forwards for International Financial Management
Objective: Evaluate the Uses of Forward Contracts
Rule of Thumb (Law of Shaft):
-
When the swap rate is at a premium, you add the larger number to the ask rate
When the swap rate is at a discount, you subtract the larger number from the bid rate
The spread is always larger on a futures contract than a spot rate, and increases with time to
maturity
𝐵𝑡,𝑇 =
∆𝑉𝑇
∆𝑆𝑇
𝐵𝑡,𝑇 denotes contractual exposure
∆𝑉𝑇 denotes change in cash flow
You may also net out all A/R’s and A/P’s on a monthly basis in order to hedge total exposure (page 165166) Duration on page 172
Tax implications (page 181)
Glossary:



Perfect Hedge: Taking a position that exactly offsets the existing exposure
Cross Hedge: The act of hedging ones position by taking an offsetting position in another good
with similar price movements.
Credit Risk: The risk of default
Chapter 6: The Market for Currency Futures
Drawbacks of Using Futures as Opposed to Forwards
i.
ii.
The contract size is fixed and is unlikely to exactly match the position to be hedged
The expiration dates of the futures contract rarely match those for the currency
inflows/outflows that the contract is meant to hedge
iii.
The choice of underlying assets in the futures markets is limited, and the currency one
wishes to hedge may not have a futures contract
Types of Imperfect Hedges
a) Cross Hedges: when currencies don’t match
b) Delta Hedges: when maturities don’t match
c) Cross & Delta Hedges: when both currencies and maturities don’t match
Hedge Ratio:
MISSING HEDGE & DELTA RATIO FORMULA (page 221)
Glossary:





Right of Offset: the right of offset allows the bank to withhold its promised payment without
being in breach of contract, should the customer default.
Marked to Market: A measure of the fair value of accounts that can change over time, such as
assets and liabilities. Mark to market aims to provide a realistic appraisal of an institution's or a
company's current financial situation.
Hedge Ratio: A ratio comparing the value of futures contracts purchased or sold to the value of
the cash commodity being hedged. The hedge ratio is important for investors in futures
contracts, as it will help to identify and minimize basis risk.
Basis Risk: The risk that offsetting investments in a hedging strategy will not experience price
changes in entirely opposite directions from each other. This imperfect correlation between the
two investments creates the potential for excess gains or losses in a hedging strategy, thus
adding risk to the position.
Margin: The amount of equity contributed by a customer as a percentage of the current market
value of the securities held in a margin account.
Chapter 7: Markets for Currency Swaps
Low Default Risk:
-
Right of Offset Clause
Companies are screened and those who are small must post initial margin
Credit Trigger Clause: stating that if the customer’s credit rating is revised downward, the
financial institution can terminate the swap and settle for the swap’s market value at the
moment.
Valuing Interest Rate Swaps (Page 255)
Also do Excel Example: Worth of a Swap is the PV of Cash Inflows – PV of Cash Outflows
In Class Example: Interest Rate Swap
Interest Rate Swap


Company XXX wants a fixed rate loan (10 years)
Company YYY wants a floating rate loan (10 years)
Company
Fixed Rate
Floating Rate
XXX
10
Libor + 2
YYY
6
Libor +1
4
1
ABS(3)
What is XXX comparatively better at?
They are only 1% worse at floating rate borrowing but 4% worse at fixed rate borrowing. Therefore they
are COMPARATIVELY better at floating. That is the type they will initially borrow at but then swap into
Fixed rate which they want.
What is YYY comparatively better at?
Fixed—They will borrow at fixed then swap into floating (which they want)
The total possible savings is: 3%, which is called the quality spread differential (QSD)
You are told that XXX will save 1 and YYY will save 2
Arrange the swap so that each saves what you stated above.
X borrows at floating (pays L+2) and agrees to get L from Y in exchange for 7%. That way X’s total cost is:
L+2 – L + 7 = 9%. If they borrowed at a fixed rate on their own they would have paid 10%. They are
saving 1%
Company Y borrows at 6% and agrees to pay (swap) L in exchange for getting 7%.
Total cost :6 + L – 7 = L – 1. If they borrowed on their own they would have paid L+1; they saved 2%.
The main benefit of Swaps: is to obtain debt financing in the swapped currency at an interest cost
reduction brought about through comparative advantages each counterparty has in its national capital
market, and the benefit of hedging long-run exchange rate exposure
Chapter 8: Currency Options (Skip: 8.3.1 – 8.3.4)
Option Value = Intrinsic Value + Time Value
Value Dead = Intrinsic Value= Value of the Option if it were to be Exercised
Key Upper & Lower Bounds
1) Options premia are non-negative: because there is a chance that the option will make money
and have a minimum value of 0
2) American-style options are worth no less than European-style options: because they contain the
right to exercise early
3) European-style call/put is worth more than the comparable forward purchase/sale: because it
have a minimum value of 0, yet shares all of the same upside
4) An American style call/put is worth at least its intrinsic value: because time value is always
positive


Buying a Foreign T-Bill = Buying a Call
Buying a Domestic T-Bill = Buying a Put
Put Call Parity: The value of synthetic options should be the same as the directly trade options, or else
there will be an arbitrage opportunity
𝐶𝑡 − 𝑃𝑡 =
𝑆𝑡
𝑋
∗ −
1 + 𝑟𝑡,𝑇 1 + 𝑟𝑡,𝑇
𝐶𝑡 𝑓 − 𝑃𝑡 𝑓 = 𝑓𝑡,𝑇 − 𝑋

Delta: The ratio comparing the change in the price of the underlying asset to the corresponding
change in the price of a derivative. Sometimes referred to as the "hedge ratio."
For example, with respect to call options, a delta of 0.7 means that for every $1 the underlying stock
increases, the call option will increase by $0.70. Put option deltas, on the other hand, will be negative,
because as the underlying security increases, the value of the option will decrease. So a put option with
a delta of -0.7 will decrease by $0.70 for every $1 the underlying increases in price. As an in-the-money
call option nears expiration, it will approach a delta of 1.00, and as an in-the-money put option nears
expiration, it will approach a delta of -1.00.
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎 𝑐𝑎𝑙𝑙
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑢𝑛𝑑𝑒𝑟𝑙𝑦𝑖𝑛𝑔 𝑎𝑠𝑠𝑒𝑡

Gamma: The rate of change for delta with respect to the underlying asset's price. Gamma is an
important measure of the convexity of a derivative's value, in relation to the underlying.
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐷𝑒𝑙𝑡𝑎
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑢𝑛𝑑𝑒𝑟𝑙𝑦𝑖𝑛𝑔 𝑎𝑠𝑠𝑒𝑡

Theta: A measure of the rate of decline in the value of an option due to the passage of a day.
Theta can also be referred to as the time decay on the value of an option. For example, if the
strike price of an option is $1,150 and theta is 53.80, then in theory the value of the option will
drop $53.80 per day.

Vega: The measurement of an option's sensitivity to changes in the volatility of the underlying
asset. Vega represents the amount that an option contract's price changes in reaction to a 1%
change in the volatility of the underlying asset.

Rho: How much does the value of the option change in response to changes in the domestic
interest rate

Rho*: How much does the value of the option change in response to changes in the foreign
interest rate
Price Increases
Strike Price Increases
Interest Rate
Foreign Interest Rate
Time
Volatility
Call
+
+
+
+
Put
+
+
+
+
DO IN CLASS PROBLEMS
Chapter 11: Do Forex Markets Themselves See What’s Coming?
Objective: Determine whether or not markets, measured by the forward rate, can predict changes in
exchange rates.
𝑠 ∗ (𝑟 − 𝑟 ∗ )
> 0 𝑤ℎ𝑒𝑛 (𝑟 − 𝑟 ∗ ) < 0 (𝐹𝐶 𝑤𝑒𝑎𝑘)
< 0 𝑤ℎ𝑒𝑛 (𝑟 − 𝑟 ∗ ) > 0 (𝐹𝐶 𝑠𝑡𝑟𝑜𝑛𝑔)
Main Points:
-
Economic models do not accurately forecast changes in exchange rates
Professionals rely heavily on technical analysis as well as fundamental analysis
There is empirical proof that the carry trade works
There is a forward bias , whereby investors have historically overestimated the change in the
spot rate
Nominal rate changes create big changes in R (Why?—sticky prices)
Forward Rate Bias: Forward rate bias is the tendency of currency markets to over-estimate changes in
exchange rates: the actual movements tend to be smaller than the expectations as measured by forward
rates
What might explain the forward bias?
1) Risky currencies provide higher returns
2) Peso risk (big losses can wipe out 10 years of gains), Career Risk (no one fired for buying
IBM)
Example of Uncovered Interest Rate Parity: Assume that the interest rate in America is 10% and the
interest rate in Canada is 15%. According to the uncovered interest rate parity, the Canadian dollar is
expected to depreciate against the American dollar by approximately 5%. Put another way, to convince
an investor to invest in Canada when its currency depreciates, the Canadian dollar interest rate would
have to be about 5% higher than the American dollar interest rate.
For the most part Fundamental analysis/models do no better than the “no change” model
In Class Example #1 – Which Prediction is best?





St = 1.05 CAD/USD
Ft,T = 1.10 CAD/USD
Victoria forecast E(ST) = 1.09 CAD/USD
Chin Forecast E(ST) = 1.20 CAD/USD
Actual result ST = 1.11
Who did the better forecast?
o Victoria can argue that she was closer to the actual value
o Chin’s expectation allows her to make money, while Victoria’s does not. If she
expects 1.09 she will not buy the 1.10 forward.
Filter Rule: If a security’s price rises, it is likely to keep rising and vice versa. Thus, those using the
filter rule set a given percentage, let’s say 1%, buy after the rise in price, as they expect the rise
to continue.
Chapter 12: Should a Firm Hedge its Exchange Risk?
Assumptions:
i)
ii)
iii)
Deviations from purchasing power parity are sufficiently large and persistent so as to expose
firms to real exchange-rate risk
It is difficult to predict exchange rates
A forward contract has a zero-initial-value property (meaning that the investor does not
expect to make a profit by purchasing and selling the contract)
𝑃𝑉𝑡 = (𝑆𝑇 − 𝐹𝑡,𝑇 ) = 0
Key Takeaway: Hedging Lowers the Risk Premium demanded by Investors and thus Increases Firm
Value
Hedging only adds value if there is a useful interaction between the hedge’s cash flow and the other
cash flows of the firm (investing, producing, marketing, servicing debt, etc.) This realizes itself primarily
in the following fashion;
Reduction of Financial Distress Costs (both ex post and ex ante)
-
A firm is said to be in financial distress when its income is not sufficient to cover its fixed
expenses including financial obligations
-
-
Outright bankruptcy is costly because of reorganization (Revenues: Loss of reputation, clientele,
etc. & Costs: lawyers, courts, assessors, etc.) and liquidation costs (fire sale versus going concern
value)
Even before a firm actually goes bankrupt, the mere potential of future financial distress can
affect the operations and the value of the firm significantly. Hence, if hedging reduces the
volatility in a firm’s cash flow, and therefore the likelihood of the firm being in financial
distress; hedging increases a firm’s value.
Examples:
-
-
-
Firms which sell products requiring warranties and after sale services are evaluated by
customers on the likelihood that they will survive the warranty period. Thus, the lower the
likelihood of bankruptcy, the more attractive the firm becomes to customers, thus increasing
revenues.
Employees working at firms with a higher likelihood of bankruptcy will demand a wage
premium. Thus, lowering the risk of financial failure, results in a smaller demanded wage
premium.
The greater the likelihood of bankruptcy, the greater the purchasing costs of the firm.
Specifically, suppliers will either demand cash payment or charge a large interest on trade credit
Loan covenants can trigger early repayment if the firm’s income falls below a stated level. This
can translate into costs associated with refinancing, restrictions placed on management,
negotiations, extra monitoring & reporting, etc.
Reduction of Agency Costs
Agency Costs: the costs that arise from the conflicts between shareholders and managers of the firm.
-
-
Given that the wealth of managers is highly concentrated in the business itself they seek
methods to hedge. However, for several reasons, it is costly and difficult to personally hedge
and thus they seek to hedge within the business itself. If managers cannot hedge the businesses
operations, they will seek higher compensation and may turn down risky projects with positive
NPV’s. Thus, the presence of hedging instruments results in lower management compensation
and improves decision making in line with shareholder interests; this increases the firm’s
value.
Equity holders are more risk-loving due to the fact that they effectively have a call option on the
firm. However, bond holders are risk-averse because they do not benefit from large positive
deviations in a firm’s cash flow as do equity holders; however, they succumb to the same
consequences in the event of financial failure. Hence, if the firm can reduce cash flow volatility
and increase bond holders’ confidence that the firm will not take unwarranted risks in order
to increase shareholder value; the company will have a lower cost of debt.
Lower Expected Taxes
-
If a company operates under a tax structure which sees the tax rate increase as income
increases (convex), there is potential to lower the average tax burden.
When earnings are negative, taxes are usually not proportionately negative
By spreading out your earnings and decreasing the likelihood of negative earnings, you can
effectively lower your average tax rate.
Homemade Hedging
....is ineffective because
i)
ii)
iii)
Investors don`t have enough information to know the total exposure
Investors will have to pay more in fees, because they are smaller in size
Investors likely don`t have access to the same hedging opportunities as the firm (e.g. large
forward contracts)
Less Noise in the Profit Figures
-
Hedging stabilizes cash flows and reduces noise. This allows for better decision making on behalf
of both company managers and investors.
Investors prefer a less noisy set of results because this allows them get a clearer picture of how
the company is doing and make more accurate predictions.
Hedging results in less noise which increases decision making and shareholder interest
Chapter 13: Measuring Exposure to Exchange Rates
Exchange Risk: Uncertainty about the future spot rate. Possible measures of exchange risk include the
standard deviation or the variance of the future spot rate exchange.
Exchange Exposure: a firm is said to be exposed to exchange risk if its financial position is affected by
unexpected exchange-rate changes
Economic Exposure


Operating Exposure: the cash flow is from future operations as opposed to past contracts.
Exposure to the degree that its market value is influenced by unexpected exchange rate
fluctuations. Such exchange rate adjustments can severely affect the firm's market
share/position with regards to its competitors, the firm's future cash flows, and ultimately the
firm's value
Contractual Exposure: contractual cash flows (receivables and payables) whose values are
subject to unanticipated changes in exchange rates due to a contract being denominated in a
foreign currency.
Hedging Operational Exposure (Can never be fully hedged)
Beta =
Change in the Firm’s Value
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑝𝑜𝑡 𝑅𝑎𝑡𝑒
If the firm has positive Beta, you can hedge by shorting the spot rate
In Class Example #1: Beta Hedge
Two options for Britain’s Central Bank:
1) They can devalue the currency to BEF/GBP 55. Your cash flows will then be 1.8M GBP
2) Alternatively, it can keep its currency at BEF/GBP 60. Your cash flows will be 1.55M GBP
What do you prefer? (REMEMBER TO TRANSLATE YOUR CASH FLOWS)
The first option, because your sales will be 99M vs. 93M for the second option
B = dV/dS
In this case: (93-99)/(60-55) = - 1.2M GBP
To hedge this exposure, you can go long 1.2M GBP
In Class Example #2: Beta Hedge w/ Probabilities
Freedonian Subsidiary Example on Page 468
(Boom Cash Flow * Spot Rate * Probability of Boom) + Bust Cash Flow * Spot Rate * Probability of Bust)
(Probability of Boom + Probability of Bust)
Result:
138−108
1.2−0.8
= 75 𝐹𝐷𝐾 → 𝑯𝒆𝒅𝒈𝒆 𝒃𝒚 𝒈𝒐𝒊𝒏𝒈 𝒔𝒉𝒐𝒓𝒕 𝟕𝟓 𝑭𝑫𝑲
Accounting Exposure: When the domestic company files its financial statements, it has to translate
revenue earned in foreign markets, back into the home currency
More Notes:


Market Imperfections, relates to costs such as bankruptcy (lawyers, liquidators) and trading fees
(half of the bid-ask spread)
Modigliani-Miller theorem, as applied to the firm’s hedging decision, states that if shareholders
(in perfect markets) can hedge the firm’s real exchange risk on their own, there is no value added
for the firm to hedge.
Chapter 21: Putting It All Together – International Finance
Step 1: Calculate the NPV -> Present value of all future cash flows minus the initial outlay
Step 2: Calculate the Adjusted NPV -> NPV + Subsidies – Financing Costs
Tax Shield = Tax Rate * Interest Rate * Principal
Problems with WACC
-
The weights used in calculating WACC are the market values, which we only know once we have
completed the valuation -> This creates a chicken and egg problem
WACC assumes that the entirety of a firms Tax Shield Gains, goes to the firm -> This is false
because some of it may go to other entities
The WACC only works for constant leverage
You should probably use different discount rates throughout the life of the project. The project
is riskier at the beginning. You undervalue the project by using a higher WACC for the later
years.
Valuing International Projects


Step 1 (Brach Stage): Focus on cash flows from operations -> Treat all financial operations by
assuming that the foreign venture is just an unincorporated branch of the parent
o Take out interest and royalties paid to others
o Don’t confuse left to right pocket transactions with out of pocket transactions
o Don’t use inconsistent discount rates
o Don’t expect tax credits will last forever
Step 2 (Unbundling Stage): The foreign venture is incorporated -> And the decision is made as to
how the foreign entity will pay remittance
o Interest Payments
o Dividends
o License Fees
o Royalties
Remit by the amount that reduces taxes. You should look at what other companies are doing as to
insure that the government will not block you.
In Class Example #1 (p.756): How Should Remittance Be paid and how much do we save?

TEK Canada pays no Taxes on Dividends Received, but 30% taxes on Royalties

TEK Brit pays 35% taxes (5% more than TEK Canada)
Thus by paying royalties TEK Brit’s revenues before they are taxed saves the firm 5% (35%-30%).
Unfortunately, the government will not allow the firm to pay 100% of its revenue out in royalties. Thus,
in this example after comparing with other companies, the firm decides to pay a royalty of 6%.
Total Savings =

𝑅𝑜𝑦𝑎𝑙𝑡𝑦 % ∗ 𝑆𝑎𝑙𝑒𝑠
1+𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒
∗ % 𝑆𝑎𝑣𝑒𝑑
Step 3 (External Financing): Adjustments are made for the effects of external financing (e.g.
issue costs and subsidies)
o Example 21. 13 (page 758)
o
The currency in which one borrows is irrelevant IF taxes do not discriminate between
interest and capital gains
In order to mitigate transfer risks should get insurance ->add present value of insurance premia to the
risk-adjusted value of the transfer risk
In Class Example #2 (page 758): Where should a firm borrow, high or low tax environment?
High Tax Environment, given that the tax shield = tax rate * interest rate * Principal, however, we must
also consider other taxes which may apply.
o
Parent Firm is in Belgium
o
Suppose tax rate = 16% in HK, 39% Belgium (Wrong: Borrow in Belgium because higher interest)
o
Interest Payment of 100 HK
o
5% dividend tax in HK (meaning that if HK subsidiary pays a dividend to Belgium, HK government
taxes 5% of that)
Must Calculate Effective Tax Rate
i)
Interest Payment * HK Tax Rate = 100 * (1-0.16) = 84
ii)
84 * (1-Dividend Tax %) = 84 * (1-0.05) = 79.8
iii)
79.8 * (1-Belgium Tax Rate) = 79.8 * (1 – 39%) = 48.678
iv)
100 – 48.678 = 51.322
v)
Effective HK Tax Rate = 51.322/100 = 51.322%
What currency should a firm borrow in, Low or High Interest Rate Countries?
Again, initially we would think that we should borrow in a high interest environment because of the
above tax shield equation
However, the currency we borrow in DOES not matter, because assuming taxes do not differentiate
between capital gains and interest income, the taxes on the capital gains or losses are exactly offset by
the taxes on the difference between interest rates
Transfer Risks (in order of most likely to be blocked):
i.
ii.
iii.
Intercompany transactions: (equity transfers, loans)—speed up payments for goods
Dividends (might want to include a domestic agency)
Interest Payments and License Fees: (make payments to bank rather than parent) (what
you can do is, instead of lending $100M to our subsidiary, we can instead lend $100M to
our bank, and borrow $100M from a local subsidiary in the emerging market—way of
circumventing). Authorities do not want to screw with the financial system, so they’re
unlikely to block this.
iv.
Payments with nonfinancial label: Management fees, payments for trade or technical
assistance (this includes consulting fees). Government might get suspicious if you
suddenly start doing consulting fees. What you do is start planning now so you’re not
starting these transactions as soon as the government blocks other types of payments.
Transfer price is the price at which related companies sell one another a product. For instance, a
subsidiary is buying something from its parents company. It should pay the number that reduces the
total amount of taxes that should be paid.
Transfer risk: is risk of getting capital out of country where you invested
Accounting for Transfer Risk in NPV/APV: check with private insurance companies (accurate, easy-tomeasure figure for which data is publically available)
Learned from Doing the Questions
-
The sum of the firm’s profits taken over time, without taking time value into account, is the
same as the project’s cash flows
The sum of a project’s investments and disinvestments, when accumulated over time is zero
Better to charge the entire investment to 1st year profit/loss
Only incremental overhead matters
Arm’s length profits is ill-defined, thus we don’t use it
You can’t just subtract costs from revenue because costs are incurred before revenue comes in.
Chapter 22: Joint Ventures
Joint Venture: A separate company used to conduct a business that is owned by two or more parent
firms
In Class Example #1 - Calculating Shared Gains:
What if the total benefit from the project was 100M and Company A’s best alternative provided them
with 20M and B’s best alternative provided them with 30M.
Remember that:
o
A firm’s gain is equal to its NPV from the joint venture minus its next best alternative
a) Gain A = X
b) Gain B = 100 –X
c) X – 20 = (100 – X) – 30
d) X = 90
e) X = 45
Therefore:


Company A Gains 45M
Company B Gains 55M
Questions:
If A faced a higher tax then B, should its share of the 100M go up or down? Up
If A had a gain in a subsidiary, would its share go up or down? Down
How the Questions are outlined (in addition to vocabulary):
Chapter 8: Options







Understand the key lower and upper bound characteristics of options (e.g. can’t trade lower
than the value of a forward contract)
Know where the value of an option comes from (e.g. Option Value = Intrinsic Value + Time
Value)
Understand qualitatively, the put-call parity theorem
Know how to graph direct & synthetic options payoff
Know how to read an options table
Know how to spot an implicit option payoff structure
Unsure if I need to do the quantitative stuff at the end of the application questions
Teacher: “A good part of the exam will likely be on options”
Focus of Final Exam
Ch.8
MC: 1,2,3
Additional Quiz: 5,6,
Applications: 1,2
Ch.11
MC 1,2
Ch.12
Valid, Invalid (All)
MC 1,2,3
Applications
4
Ch.13
Matching Questions: All
Operating Exposure (T/F All)
MC Attempt the MC, but I do not expect you to fully understand. But give them a go. Also attempt the
application question
Ch. 21
Try all the quiz questions